“Woe to the land whose king is a child and whose leaders are already drunk in the morning. Happy the land whose king is a nobleman, and whose leaders work hard before they feast and drink, and then only to strengthen themselves for the tasks ahead”. (Eccl 10: 16-17)

"When misguided public opinion honors what is despicable and despises what is honorable, punishes virtue and rewards vice, encourages what is harmful and discourages what is useful, applauds falsehood and smothers truth under indifference or insult, a nation turns its back on progress and can be restored only by the terrible lessons of catastrophe." … Frederic Bastiat

Evil talks about tolerance only when it’s weak. When it gains the upper hand, its vanity always requires the destruction of the good and the innocent, because the example of good and innocent lives is an ongoing witness against it. So it always has been. So it always will be. And America has no special immunity to becoming an enemy of its own founding beliefs about human freedom, human dignity, the limited power of the state, and the sovereignty of God. – Archbishop Chaput

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Saturday, April 16, 2011

I misinterpreted my own chart when putting together this article and drew an erroneous conclusion. The ratio of GDX to GDXJ indicates whether or not the large caps are outperforming or underperforming the small and mid sized caps (juniors and mid tiers) in general. If this line is falling, it means that the large cap miners are UNDERPERFORMING against the juniors and mid tiers as a general rule of thumb, not as I originally stated in this article below.

I generally field emails from those who are rightly disappointed about the overall performance of some of their gold and silver shares. In nearly every case, the shares that they mention are juniors. That set my mind in a frame that was disposed to look for weakness in the juniors when compared to the majors. As such I incorrectly read my own chart and drew the opposite conclusion to what the actual ratio line indicates. I apologize for this as I should have caught it in the first place.

I should note here that even with this ratio doing what it is doing, many of the juniors are still seriously lagging the performance of the underlying metals. Some juniors and mid tiers have had a stellar performance but many of them are stuck apparently dead in the water. These are the issues that are being leaned on by the hedge funds and it is this which is the source of the constant selling interest that does not seem to let up. Keep in mind however that for every seller, there must be a buyer. Someone is on the other side of the short selling.

The original article now follows:

At the suggestion of my good friend Jim Sinclair, I have prepared a chart detailing the ratio of the price of GDX compared to the price of GDXJ.

The GDX does contain some smaller cap miners but it also mainly includes the large cap mining outfits.

The GDXJ on the other hand, is comprised entirely of medium cap and small cap miners.

Over 60% of the stocks that make up the GDXJ are Canadian firms. Nearly 14% are US headquartered with 13.31% being Australian. The remaining are from various countries around the globe.

While not a perfect representation, it is a useful tool for charting the underperformance ( in general) of the small and medium cap miners compared to the larger cap miners.

Note the steep decline in the line that began in the summer of last year which lasted throughout the remainder of 2010. Only towards the end of last year did the juniors recover a bit of ground but the best they could do was to retrace a small portion of their losses against the large cap miners by moving higher but since January they have gone nowhere against the large caps.

It seems to me that the hedge funds are selectively targeting some of the small and mid tier mining firms to go after with their short side of the spread trade that they have been employing. Perhaps they feel that due to their sheer size and financial firepower, they can overwhelm any buying coming into the smaller firms and thus create an effective put option against their long metals positions. I am not sure but either way, the chart reveals the reason for the frustration among many who own quality junior and mid cap mining firms whose share prices seem stuck in the mud even as the gold and silver markets continue soaring higher.

Let me take this opportunity to also clarify something in my earlier post about the HUI and XAU ratio charts. I did not mean to imply that the mining shares are trading at the same level as they were back in 2001 when silver was $4.00. That is of course preposterous as most have had strong gains over the last decade. The ratio charts' purpose is to show whether the shares are underperforming or outperforming physical gold and/or silver. What the charts do show however is that the mining shares in general have so seriously underperformed the gains in both gold and silver, that the ratio of the indices to the underlying metals is ridiculously skewed. In the case of silver, you have to go all the way back to 2001, a period in which very few people were calling for a major bull run in the metal. There was little if any excitement whatsoever in the mining sector back then.

In regards to silver in particular, the ratio of the HUI and the XAU to it may not be as good of a gauge of how the silver stocks in particular are performing when compared to the price of the bullion, mainly because both indices are dominated by gold producers, particularly the HUI, but both indices do hold silver miners in their basket as well as some gold miners who produce both gold and silver. Since silver has been outperforming gold on a percentage basis, and both of these indices favor a larger number of gold producers than silver, it is reasonable to assume that both of the indices would be lagging silver when a ratio is constructed, but not to this extent. To see these indices trading at such extremely low levels when a ratio is created is indicative of the kind of short selling pressure that is active in the mining sector in many instances.

It is just mindboggling to see how undervalued many of the shares are when compared to the metals. While many have moved strongly higher, a large number of them continue to lag and are not reflecting the kind of price movements that we would expect to normally see with the bullion making either all time highs in price or 30+ year highs.

If you want to get a "fair" or reasonable level at which the indices should be trading, run some statisticial analysis and see what the mean or average value should be then see what the standard deviation away from that mean is. I will leave that to my statistics friends but either way, the result is indicative of how cheap the stocks are compared to the metals in many cases.

Here are a few of the silver stocks comparing them to the price of silver and creating a ratio chart. A rising line indicates the stock price is outperforming the price of silver. A falling line indicates the stock is underperforming.

I hope to have further on this topic sometime this weekend depending on time constraints but I wanted to at least get some charts up to demonstrate how severely undervalued many of the mining shares are in relation to the underlying metal as a result of the plying of this particular trading strategy.

One of the factors that I believe are involved with this severe underperformance of the shares in general is the advent of the ETF's. Those who want LEVERAGED EXPOSURE to either or both gold and silver can now use the ETF's to do so.

Formerly, there were two methods available - commodity futures or mining shares. Since the charters of some funds prevents them from investing or trading in commodity futures, funds who wanted this leveraged exposure to the metals were forced to go into the mining shares in the past. That implied that bull markets in the metals were going to see substantial money flows coming into the shares.

Since the ETF's came along, those institutions looking for leveraged exposure to gold can now directly purchase the silver or gold ETF's instead and margin those up to obtain leverage. In other words, they are no longer captive to using only the mining shares.

Additionally, the hedge funds, which have proliferated like mushrooms after a summer rain, are able to offer prospective clients exposure to the commodity markets since there is nothing in their charters preventing them from investing in the commodity markets. That attracts further funds that in time past would have flowed into the mining sector directly.

Keep in mind what is necessary to drive prices higher - sustained investment flows. Now, if the investment flows that formerly would be diverted directly to the mining shares have been split and are now moving directly into the commodity futures markets and the ETF's, that pulls a portion away from the shares. That means that there is a bit of an exploitable weakness, a chink in the armor if you will, in the sense that the amount of firepower coming into the shares, is weaker when compared to the other alternative forums for investing in the precious metals.

The hedge funds understanding this then employ a strategy designed to take advantage of the "weaker sister" which suffers somewhat from the smaller money flows heading its direction - they short some of the mining shares while buying the commodity futures and the ETF's. That selling then further absorbs the buying interest that is still heading into the mining sector shares.

The reason they do this is because it helps them manage their risk. When the market sells off in this volatile environment, they are able to profit from the short leg of this trade as the shares head lower generally at a faster rate than the metals themselves do. In other words, they might be losing $1.00 on their long gold or silver positions in the futures or ETF's, but making $1.10 - $1.20 on their short share position. In effect, they have a permanent put option.

This trade has been extremely effective for them which is why they seemingly refuse to give it up but at some point, the effect is to so distort the price of the mining shares in relation to the underlying metal, that something has to snap to bring the share price back in line to historical norms. After all, the higher the metals run in price, the more profitable the well run miners become. Stock prices are eventually determined by profits - Eventually some of the hedge funds plying this trade will begin to realize that they are pushing the trade too far and will begin to exit. That will set off a rush by the others to do the same.

We got a brief taste of this April 5 of this year when the HUI shot up nearly 30 points in a single day. That was the first sign that the days of this trade are drawing to a close. There is an old adage in the trading world which is apropos for this situation:

Bulls make money; Bears make money; but Pigs get slaughtered.

Hedgies beware. The time is coming when there are not going to be any sellers on the other side of your trade when you need to unwind it.

If you have benefitted from some of the articles posted here and would like to express your gratitude to Trader Dan for freely sharing some of the market wisdom he has gained over his long trading career, please feel free to Donate.

About Me

Dan Norcini is a professional off-the-floor commodities trader bringing more than 20 years experience in the markets to provide a trader’s insight and commentary on the day’s price action. His editorial contributions and supporting technical analysis charts cover a broad range of tradable entities including the precious metals and foreign exchange markets as well as the broader commodity world. He is a frequent contributor to both Reuters and Dow Jones as a market analyst for the livestock sector and can be on occasion be found as a source in the Wall Street Journal’s commodities section as well as CBS Marketwatch where his views on the gold market can often be found.
He is also an avid beekeeper.

The charts and analysis provided here are not recommended for trading purposes but are instead intended to convey general technical analysis principles. Trade at your own risk. Futures trading in particular is fraught with peril due to extreme market volatility.

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